The twists and turns of covered call ETFs

When a new type of investment product appears, wait at least a year or two before buying so you can get a sense of how it behaves.

This rule of investing came to mind after reviewing the performance of covered call exchange-traded funds in the year or so since they came to market. One of the biggest players in covered call products says it's satisfied with the results of its funds to date, and two money managers said they are, too. But individual investors have had to contend with some twists and turns that they may not have expected.

"I was truly excited when I discovered the covered call ETFs structure last year," a financial blogger known as The Dividend Guy wrote in a recent post. "I'm far from being excited now."

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Covered call ETFs have attracted a robust $2-billion or so from investors who have been drawn by rich yields that currently range from 7 to 19 per cent or so. These ETFs use a strategy where you buy stocks and write, or sell, call options that allow other investors to purchase your shares at a predetermined price. Selling call options helps produce a flow of income that to the untutored eye can resemble dividends paid by blue-chip stocks and interest from bonds.

With quality bonds and blue-chip stocks, you know precisely how much money you'll get every three or six months. Covered call ETFs are a surprise from month to month because the flow of premiums generated from covered call writing rises and falls along with the level of stock market volatility.

Market volatility is at lower levels than last year, which means the monthly payments from covered call ETFs have declined. Example: The monthly payout by Canada's biggest fund of this type, the BMO Covered Call Canadian Banks ETF (ZWB), fell to 8.5 cents this year from 10.1 cents in late 2011 before rising back to 8.8 cents in June.

Covered call ETFs have also shown that in a declining stock market, they often don't deliver the downside protection investors might expect from a product designed primarily to generate income. Take the Horizons Enhanced Income Equity ETF (HEX), which has lost 13.6 per cent from its inception date in March, 2011, through the end of June. Note: This is a total return, which in the case of covered call ETFs may include income from call writing, dividends and price changes for the stocks in the portfolio.

HEX holds shares in 30 of the biggest, most liquid TSX-listed stocks in equal measure. A roughly comparable investment vehicle is the iShares S&P/TSX 60 Index Fund (XIU), which holds shares of 60 big companies and weights them according to their size. XIU's total return over the same period that HEX was measured was a loss of just under 12 per cent. Plain-vanilla XIU beat HEX's covered-call complexity over a single year by 1.6 percentage points.

Eden Rahim, manager of Horizons' covered call lineup, said the underperformance of HEX is due to the fact that its equal-weight format meant it had more exposure to the weak commodity sector than XIU and less to more stable financials. In looking at the entire lineup of Horizons covered call ETFs over the past year of market ups and downs, he said there has been a consistent pattern where income generated by covered call writing has helped to offset losses in the underlying portfolio of stocks.

In general, Mr. Rahim describes the performance of Horizons covered call products as "in line with expectations." Money managers seem to be satisfied with them as well.

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Larry Berman of ETF Capital Management said he likes the way covered call ETFs make the covered call strategy accessible to individual investors. "The average guy wouldn't otherwise have the experience or know-how to do it on his own, and most advisers aren't [licensed to sell options]," he said.

Mark Yamada, president of PUR Investing, said covered call ETFs have performed just as he expected in the past year. He describes them as offering "a slightly cushioned approach" to investing in the stock markets.

But Mr. Yamada also has some issues with covered call ETFs. For one thing, he thinks there should be more focus on the variability of the monthly payouts on these products. Published yields are calculated by looking back at previous payouts and don't offer much insight into what's ahead.

He also thinks there's a lack of understanding of how these ETFs work in general. "The reality is, you're creating a new instrument, with different risk, return and payout characteristics."

Horizons' Mr. Rahim said covered call ETFs should, over a period of five years or longer, deliver returns that are 1.5 percentage points higher on average than comparable stock market ETFs. He said covered call products will underperform in fast-rising market and outperform in sideways and down markets. Sometimes, the outperformance will come in the form of losing less money.

As for the variability of the monthly payouts, Mr. Rahim said they're simply a function of how volatile the markets are. "We earn what the market will give us and we pass it through to investors," he said.

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Financial industry pros make covered call ETFs sound simple, but they can be frustrating for individual investors. The Dividend Guy blogger – he wants to be known only as Mike – said he owned the BMO Covered Call Canadian Banks ETF for about a year because he wanted a source of income in uncertain market conditions and preferred not to own more bonds.

In a recent blog post (bit.ly/LCFJbT), he calculated that ZWB performed pretty much the same as the average for the Big Six banks on a total return basis, minus fees. His conclusion was that ZWB isn't for him. "Tomorrow morning, if I had to buy again in my situation as a young investor, I'd probably forget about it and buy bank stocks," he said in an interview.

We'll need a full cycle of stock market ups and downs to properly judge covered call ETFs, but the experience of the past year is worth noting. It shows that while covered call ETFs pay monthly income, you have to be prepared for ups and downs in the amount you receive. It also suggests that these ETFs may outperform in sideways or down markets, but you can't count on that. So far, these ETFs seem better in theory than in reality.

Rob Carrick has been writing about personal finance, business and economics for close to 20 years. He joined The Globe and Mail in late 1996 as an investment reporter and has been personal finance columnist since November 1998.Rob's personal finance columns appear in The Globe on Tuesday and Thursday, and his Portfolio Strategy column for investors appears on Saturday. More

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